THERE WAS long-overdue drama at a Capitol Hill hearing Thursday. We are referring, of course, to Treasury Department counselor Antonio Weiss’s testimony before the Senate Committee on Energy and Natural Resources, in which he warned of a looming “humanitarian crisis” in the financially distressed commonwealth of Puerto Rico. Mr. Weiss’s words marked a break with the Obama administration’s previous low-key approach to the island’s debt crisis, and if he resorted to hyperbole to compensate for that, it was only slightly. Having already cut spending, jacked up taxes and postponed various bill payments, Puerto Rico is out of cash and facing a year-end liquidity crunch that could lead to a breakdown in public services, or even public order.

Mr. Weiss backed up his words with the administration’s most comprehensive policy proposals yet, the most important of which would require congressional action. Specifically, he advocated not only permitting Puerto Rico’s municipalities and public corporations to file for bankruptcy, which would affect about a third of its $73 billion debt, but also extending the bankruptcy option to the commonwealth government itself. He called for a permanent fix to the island’s Medicaid program, which faces crippling uncertainty because of limits on federal assistance unlike those of the 50 states. And to address its lagging labor force participation – a huge drag on economic growth – he proposed creating an Earned Income Tax Credit to encourage low-wage workers’ return to the job market.

In short, for the first time the executive branch has put its weight behind solutions that would cost money, billions of dollars of it. A good benchmark would be Gov. Alejandro Garcia-Padilla’s projection of a $14 billion hole in the island’s finances over the next five years. The administration’s plans for Medicaid and an EITC would put U.S. taxpayers on the hook. Bankruptcy would be the mechanism through which creditors chip in; an average 40 percent “haircut” on their bonds is probably in order, according to a recent study by BlackRock. As the example of Detroit shows, letting an impartial bankruptcy judge sort out the competing claims on a failed public entity is the fairest, most efficient approach; without that option, Puerto Rico has no leverage in debt negotiations, and litigation could ensue.

The Obama administration urged Congress to move quickly to address Puerto Rico's debt crisis after commonwealth officials warned they might run out of money before the end of the year.

“Given the commonwealth’s projection that it will exhaust its liquidity later this year, Congress must act now to provide Puerto Rico with access to a restructuring regime," the Treasury Department said in a press release after Treasury Secretary Jacob Lew met with the territory's Gov. Alejandro García Padilla on Thursday. "Without federal legislation, a resolution across Puerto Rico's financial liabilities would likely be difficult, protracted, and costly."

The letter suggested to some observers that the administration wants to go beyond the bankruptcy legislation proposed so far, and that Puerto Rico itself - and not just its public corporations and municipalities -- should be given access to a restructuring process.

Earlier this year bills were filed first in the U.S. House of Representatives and then the U.S. Senate to allow Puerto Rico's cities and public corporations to use Chapter 9 bankruptcy for their debts. The bills have yet to advance. Less than half of Puerto Rico's $71 billion of debt is owed by public corporations and municipalities.

On July 28 United State Secretary of the Treasury Jacob Lew wrote a public letter to U.S. Sen. Orrin Hatch saying that, "a central element of any federal response should include a tested legal bankruptcy regime that enables Puerto Rico to manage its financial challenges in an orderly way." This may have been a reference to Chapter 9 bankruptcy, the only "tested bankruptcy regime" for U.S. government entities.

In a story by InterNewsService published Thursday on the El Vocero news web site, Puerto Rico Secretary of the Treasury Juan Zaragoza said it was possible that Puerto Rico's government would run out of operating money in November.

WASHINGTON – Resident Commissioner Pedro Pierluisi, D-P.R. and others testifying at a Senate committee hearing on Puerto Rico on Thursday said that it’s possible that some of territory’s debt may be unconstitutional and, if that is the case, it should not be paid.

Presidential candidate Sen. Bernie Sanders, I-Vt., a member of the Senate Energy and Natural Resources Committee, told Pierluisi and Gov, Alejandro Garcia Padilla, who both testified at a hearing held by the panel, that he understood some of the debt may have been incurred in an unconstitutional manner. He asked them if this is true. Garcia Padilla said, “Yes ... if that is the possibility, the answer is yes.”

Pierluisi said there is an attorney general opinion that provides support for the interpretation that some of the debt could have been issued outside the territory’s Constitution. “It is a legal issue and it’s something that should be studied, but you may be right,” he told Sanders.

Sanders asked if debt that was incurred unconstitutionally should be repaid. Both Pierluisi and Sergio Marxuach, policy director at the San Juan-based Center for a New Economy, said no, it should not be repaid. Garcia Padilla did not respond to that question.

Marxuach said Puerto Rico’s Constitution specifies that debt should not be issued to balance the budget, that instead taxes should be raised. But he said that was disclosed in official statements for the debt.

Pierluisi, a non-voting member of Congress, said, however, that Puerto Rico should fully pay holders of the $18 billion of debt that is guaranteed by the territory’s Constitution, suggesting that debt would be outside of any bankruptcy proceedings, if access to Chapter 9 is granted.

Garcia Padilla stunned some observers by saying that the territory’s financial disclosures have always been “a historical problem,” in part because of previous efforts to “hide information from the market” to attract more investors to buy the debt.

Earlier this year, in a report commissioned by Puerto Rico’s government, three international economists described the territory’s woes. While the report scored the territory for its lack of fiscal controls in the face of a struggling economy, the economists also argued that Puerto Rico suffered because it was forced to adhere to federal laws that have “gnawed at growth.” The “single most telling statistic in Puerto Rico,” they wrote, is that only 40 percent of the working-age population is employed. The biggest obstacle to jobs, the report argued, is that the territory must observe federal minimum-wage law, even though incomes in general are far lower on the island than in U.S. states. A full-time worker in Puerto Rico making minimum wage earns 77 percent of the average wage on the island, compared with just 28 percent in U.S. states. The cost of paying even an unskilled worker is so high that “employers are disinclined to hire.” Even more foolishly, welfare benefits on the island—including food stamps, Medicaid, and subsidies for utility bills—approach mainland levels. Recipients can garner benefits equal to $1,743 a month, more than the average wage on the island. “The result,” the report notes, “is massive underutilization of labor, foregone output, and waning competitiveness.”

Puerto Rico also suffers from the ill effects of the union-friendly Jones Act—a 1920 law that drives up the cost of goods by forcing ships traveling between U.S. ports to be built and manned by Americans. The restrictions have a particularly devastating effect on the cost of transporting goods to and from U.S. island territories or states, such as Puerto Rico and Hawaii. Neighboring islands that aren’t U.S. territories pay far less. “Exempting Puerto Rico from the U.S. Jones Act could significantly reduce transport costs and open up new sectors for future growth,” the economists’ report argues. Other factors impeding Puerto Rico’s growth include complex local regulations on banking, an inefficient energy sector that drives up the price of power, and difficulties in registering property, obtaining business permits, and paying taxes. As the economists observe, the territory ranks 47th (out of 189 governments) in the World Bank’s ease-of-doing-business index. The United States ranks seventh.

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In the past, Republicans in Washington took a dim view of granting bankruptcy for Puerto Rico. But the GOP may be ignoring an opportunity that the Puerto Rico crisis presents for dealing with a problem closer to home: the state and local pension crisis. With his proposal, President Obama was careful to wall off the municipal bankruptcy code from larger changes. He and his political allies, especially public-sector unions, fear that helping Puerto Rico might make it easier for municipalities or other entities within states—including deeply indebted pension systems—to file for bankruptcy protections. In places like Illinois, New Jersey, and California, where taxpayers’ efforts to reform public-sector debt run into one stumbling block after another, bankruptcy might be the only way of clearing away these steep fiscal obligations. The GOP should use Obama’s Puerto Rico gambit, clearly a political ploy, to start a discussion on municipal debt that the administration and its allies would rather not have.

Moody's Investor Service on Wednesday said Puerto Rico is likely to default on at least some of its $355 million in debt payments due Dec. 1, citing growing liquidity pressures.

The U.S. commonwealth, facing around $70 billion in total debt, is struggling to breathe life into a stalled economy with a roughly 45 percent poverty rate. In a note on Wednesday, Moody's, which has rated Puerto Rico Caa3 negative, said the island "continues to operate with extremely limited internal liquidity and no access to external sources of financing."

"The government projects a negative $29.8 million cash balance in November, growing to a deficit of $205 million in December," Moody's said.

The debt due on Dec. 1 was issued by Puerto Rico's Government Development Bank. About $273 million of it is so-called general obligation (GO) debt, which is considered the island's highest priority debt and protected by its constitution.

The GDB has said it will make the payment, but Moody's was skeptical, noting that Puerto Rico has another $330 million in GO debt due on Jan. 1.

Since July, the commonwealth has not been making its monthly sinking fund payments on the Jan. 1 debt, instead saying it plans to use cash in the island Treasury department's account at the GDB. According to Moody's, however, the projected November and December balances in that account are negative.

Update: So it would seem that Puerto Rico repurchased the bonds in question here in fiscal year 2012. (I am still a little unclear on the details of how that decision was made.See page 51.) But since Puerto Rico is YEARS LATE in financial disclosure, everyone has been puzzling over why the Commonwealth chooses to use its liquidity this way. I am still puzzling over its gratuitous insurance premiums.

Puerto Rico is expected to default on at least some of the $354 million of principal and interest payments its Government Development Bank (GDB) has coming due on December 1st. This will be the Commonwealth’s first default on its direct debt, and the Commonwealth’s general obligation bonds are likewise expected to be in danger.
So it was curious that Ambac was boasting during its 3rd Quarter Earnings Call that Puerto Rico had decided to repurchase $228.5 million of Puerto Rico Highway and Transportation Authority (PRHTA)bonds for apparently no reason at all. The GDB has previously repurchased variable rate PRHTA bonds where credit enhancement had become unfeasible or had failed to be extended, but that was obviously not the case here.

This is a government that is in the middle of a liquidity crisis, on the verge of a government shutdown, that has already deprived money due to numerous other parties for the sake of providing essential government services. And officials — and their army of professional advisors — just arbitrarily relieved Ambac of a large exposure.

(For a discussion of the terms of Ambac’s insurance policies and why this action definitively relieves Ambac of its contractual responsibilities, see bond documents.)
Why did this happen? Was this a $228.5 million administrative error? Was this a negotiated agreement? If so, what relief is Puerto Rico getting in return?
If what Ambac is claiming is accurate, Puerto Rico has unfairly denied investors funds they are due through this action. This is just another example of why immediate federal intervention is required.

New York City’s $53 billion civil-employees’ pension is urging its hedge funds and distressed debt managers that hold Puerto Rico bonds to “find a just and equitable solution” to the commonwealth’s debt crisis.
The New York City Employees’ Retirement System has assets managed by at least eight money managers that own pieces of the island’s $70 billion debt. As prices of Puerto Rico bonds plummeted and yields soared, hedge fund and distressed-debt buyers swooped in. They now hold as much as 30 percent of Puerto Rico’s securities, according to Barclays Plc.
“Some hedge fund and other institutional investors’ reaction to the crisis suggests they will seek to impose draconian terms and conditions on Puerto Rico’s bond issuing entities,” according to a letter sent by the trustees of the New York City Employees’ Retirement System, one of the city’s five pension funds.
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A report commissioned by some of the hedge funds by former International Monetary Fund economists said Puerto Rico could avoid defaulting by cutting spending, improving tax collections and selling its ports and other real estate.
Hedge funds have disputed the characterization that they are an obstacle to resolving the island’s crisis. Such funds and other investors holding bonds from the Puerto Rico Electric Power Authority, or Prepa, agreed on Nov. 5 to a restructuring plan that would require them to take losses of as much as 15 percent.
“Blanket statements criticizing the role of bondholders aren’t just factually inaccurate, they are a clear example of damaging political rhetoric,” Stephen Spencer, a managing director at Houlihan Lokey who is advising Prepa bondholders, said ahead of the pension fund’s statement.

Puerto Rico has a total of $467M due to creditors on Dec. 1, and another $958M on Jan. 1, with Moody's expecting a default on at least some of the $354M in Government Development Bank bond payments on Dec. 1.

"We are concerned that that any near-term positive headlines will quickly be usurped by negative ones,” says analyst Ed Groshans. “Any positive momentum achieved from the encouraging signs in recent days could be sapped by missed bond payments between now and January 1. ”

Higher today by more than 1%, MBIA (MBI +2.1%) is down 18.4% over the last five sessions, and Assured Guaranty (NYSE:AGO) by 9.8%. Ambac (NASDAQ:AMBC) is down 12% during that time.

Puerto Rico Lawmakers Set Special December Session
BY ALEXANDER LOPEZ, BLOOMBERG NEWS
Puerto Rico Governor Alejandro Garcia Padilla will convene an extraordinary session of the commonwealth’s legislature in the first week of December after lawmakers failed to address a bill he recommended that would authorize the restructuring of the island’s main electric utility.
The regular legislative gathering ended Tuesday. Under terms of a debt restructuring agreement reached earlier this month by the Puerto Rico Electric Power Authority and some bondholders, the legislature must approve the plan by Nov. 20 or investors can terminate the pact.
An extension of the deadline is possible. Bondholders agreed last week to give the utility more time to negotiate with insurers who have objected to the terms. They extended preliminary talks 13 times in the past year.
Lawmakers did pass legislation late Tuesday to create a fiscal adjustment board that will be comprised of five members to be chosen by the governor and approved by the commonwealth’s Senate. The governor expects to sign the bill into law this week, a spokesman said.

What can be done?
Puerto Rico is currently in a vicious cycle: poor fiscal outcomes lead to higher interest rates and debt service costs, requiring higher taxes and service cuts, which in turn create incentives for citizens to locate elsewhere, like Florida, further worsening the fiscal situation. In our earlier reports, we suggested several mechanisms for breaking this cycle, and restoring fiscal stability and growth to the Island’s economy.

Some recent discussions have focused on restructuring debt to achieve the same end. How exactly that might be done is unclear. Absent a legal framework to manage a restructuring, the process could quickly become very costly to all the parties involved. A default would lead to potentially hundreds of creditor lawsuits and attempts to attach assets. Currently, Puerto Rico has no legal framework under which it can resolve its public debt burden so restructuring would likely exacerbate the vicious cycle, with ever-increasing levels of social and economic costs.

In the fifty states, Chapter 9 of the U.S. Bankruptcy Code provides a mechanism for the orderly resolution of debts of municipalities, avoiding the high costs associated with prolonged legal battles and the potential for disruption of public services. But Chapter 9 doesn’t currently apply to Puerto Rico. To fill this gap, the Commonwealth passed the Corporations Debt Enforcement and Recovery Act (aka the “Recovery Act”) in 2014. But a July 2015 federal Appeals Court decision held that by excluding Puerto Rico from Chapter 9, Congress “preserved to itself that power to authorize Puerto Rican municipalities to seek Chapter 9 relief,” and that the Recovery Act thus violates the Supremacy Clause (Article VI) of the U.S. Constitution.

Providing a framework for an orderly restructuring process will most likely involve some kind of bankruptcy regime for the Commonwealth and its municipalities. In the language of Chapter 9, “municipalities” are political subdivisions or instrumentalities of states; states themselves are not eligible to file for bankruptcy protection under Chapter 9. Thus, a direct application of Chapter 9 to Puerto Rico (that is, treating Puerto Rico as if it were a state) would allow for the possibility that the debts of the public corporations and agencies, along with municipality debt, would be subject to protection from creditors. As shown in the table above, these debts totaled $24-28 billion as of June 2015, representing less than 40 percent of total Commonwealth debt. Reducing or rescheduling these debts would offer some relief to the Commonwealth. (It’s less clear how some special kinds of debt like COFINA and the Commonwealth’s pension bonds would be treated under this version of Chapter 9. Deciding this would likely be a costly and time-consuming process.)

Of course, Puerto Rico is not a state, and an alternative approach would be to devise a mechanism that would also apply to the obligations of the Commonwealth itself, rather than just to those of its subdivisions. Such a mechanism could include all $71 billion shown in the table, an amount roughly equal to Puerto Rico’s GNP, and would render irrelevant any ambiguity about exactly what is an obligation of the Commonwealth versus a subdivision. Including a more comprehensive set of obligations would offer significant debt relief and the potential to share the burden of restructuring over a broader set of creditors.
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COMMENTS

Thanks, Cate, for the comments. As you point out, PREPA was very close to an agreement with its creditors when you wrote the comment and a restructuring deal was reached last Thursday with some of them. That deal, however, doesn’t include everyone – the bond insurers are excluded - and it’s not clear what the economic impact will be for PREPA and its ratepayers. So we would argue that the jury is still out on how that deal will proceed. In any event, PREPA has been negotiating with its creditors since at least July 2014 so this hasn’t been a quick or easy process. A couple of other brief responses: While it’s true that public sector employment in Puerto Rico in the month of September was up very slightly – about 1,000 jobs – since the same month a year ago, it is down almost 25 percent (about 76,000 jobs) since 2008. It’s also true that up-to-date audited financial statements for some of the Commonwealth’s entities aren’t available, but in our view there is more than enough reliable information to conclude that Puerto Rico’s fiscal situation is quite serious.
Posted by: Blog Author | November 09, 2015 at 01:56 PM
The authors miss some important points:
1) The Krueger report assumes full amortization of debt which is a nice goal but something very difficult to achieve without substantial fiscal reductions.
2) Puerto Rico's electric utility, Prepa, is near agreement with bond insurers, bondholders and fuel line lenders to restructure approx $9 billion in debt outside of federal bankruptcy. It is possible that other classes of PR debt could also be consensually restructured.
3) Puerto Rico's central government has increased the number of employees in the last year although the island has lost population.
4) More precisely PR schools lost 8% of their enrollment this year but the PR Dept of Ed is moving 800 central admin employees into schools instead of downsizing.
It is very difficult for Congress to create a structure to haircut bondholders when the island has done little to reach a balanced budget. Also 4 units of the central government cannot get KPMG to sign off their 2014 financials so no one really knows what their financial condition is.
Posted by: Cate Long | November 03, 2015 at 01:20 PM